Is It Possible You’re Saving Too Much For Retirement?

In a recent discussion with my accountant, we talked about my family’s retirement accounts and long-term investing goals. We both came to the conclusion we should focus on adding more to our taxable investments. We already have a sizable nest egg in retirement accounts.

Though I don’t plan on formally retiring really ever, it is possible to be lopsided and have too much in retirement accounts and not enough in taxable investments. With retirement accounts it’s possible you are saving money on taxes now, only to get walloped with a bigger tax bill in the future.

I certainly believe investing to be tax efficient is critical. Though at the end of my post on the subject, I also said “Keep in mind like any part of investing, one should not invest solely for tax avoidance.”

Most personal finance books say you should put away the maximum possible in retirement accounts. What they don’t talk about is when you have to start withdrawing money from your retirement accounts. They only talk about the accumulation phase, and all state your expenses are lower after you retire. Another Suze Orman type financial advice that doesn’t always apply to everyone.

Yes, income from a salaried position decreases but keep in mind for tax purposes distributions from retirement accounts (except Roth accounts) are taxed at ordinary income rates. It’s possible your tax rate is much higher when you retire.

Tax-deferred accounts does NOT mean tax avoidance.

I Have To Pay More In Taxes When I Retire?!?

Let’s use a hypothetical to show what I mean. Let’s say you currently have $1 million saved for retirement at 40 years of age. A lot of money for that age, but not an impossible goal. Especially if you are a married couple and you start saving for retirement right out of college. You don’t plan on retiring until at least 60 years of age, so you have 20 more years of investing with your retirement account. Assuming a 7% rate of return, and socking away an additional $25k annually, you’ll have approximately $4,500,000 by that time.

The problem is two-fold with retirement accounts: you have minimum required distributions starting at age 70 1/2, and any money you do take out is taxed at ordinary income rates. Currently long term capital gains and dividends are taxed at a lower rate than regular income. While this may change in the future, historically investment taxes are at a lower rate than income taxes.

So let’s assume you take out 4% annually from that retirement account, or $180,000. At today’s tax rates, that puts you in the 28% tax bracket. Obviously this isn’t counting for inflation, so let’s use the next lower tax bracket of 25%. That’s still higher than if it were all investment income and/or dividends in a taxable account – currently taxed at 15%. In other words, $18,000 more in your pocket annually if it were in a taxable account. So while you save taxes when socking away this money, it’s possible you lose this advantage when you start taking it out. Especially if you need large sums of money in any tax calendar year. With state taxes included, it can be as high as a 50% total tax rate. Ouch!

Obviously, if you are going to invest in taxable accounts, you should only use tax efficient investments, but they can be part of your total asset allocation. That means NOT using investments like REITS, bond funds, or dividend paying stocks (if possible). ETFs like Vanguard’s Russell 3000 Index ETF (VTHR), which cover the entire market, are pretty tax efficient. There are other funds that are specifically designed to minimize taxes as well, but also to track various indexes. These are perfect investments to place within taxable accounts. What you are setting up is a blend of tax deferred and taxable accounts.

Disadvantages Of Retirement Accounts

  • Retirement accounts are much more restrictive – By most situations you can only start withdrawing from them when you are 59 1/2 years old (55 in some situations). If you need the funds sooner, be prepared to pay a massive penalty.
  • Assumes you are in a lower tax bracket when you retire. While this might be true for most people, it’s not for everyone. Retirement accounts are taxed at regular income levels. As we all know, tax rates are going up and are not expected to go down for the foreseeable future.
  • Restricted investment selection – I, for example, love real estate rental properties. While it’s possible to invest in real estate with a self directed IRA account, I don’t consider that a viable option. Also, many retirement accounts have a poor selection of funds to choose from.
  • Required distributions – With the exception of Roth accounts, you are required to take money out of your retirement account starting at 70 1/2.
  • Taxed at ordinary income rates – This is perhaps the killer if you only put money into a retirement account. You are taxed at ordinary income rates. Depending upon other sources of retirement income and amount saved, it’s possible you are in a higher tax bracket than before retirement. Also taxes in the future are an unknown.

Bottom line, it makes sense to have a mixture of tax deferred and taxable accounts. It gives you much more flexibility when you retire. So while it makes sense to minimize your taxes while saving for your retirement, you should also be concerned after you retire. Obviously I’m not suggesting stop putting money into your retirement account, especially if your company does matching.

What I am suggesting is once you get past some level of retirement savings, you may want to balance it more out with taxable investments as well. With taxable accounts you have not only more flexibility with investments, their intended use, more control over when you have to pay taxes, and traditionally at a lower tax rate to boot!

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Reader Comments

  1. Brett Wilson says

    I think that it is possible to save too much for retirement. Individuals also shouldn’t risk missing out on important life opportunities because they are saving for retirement.

  2. says

    @Larry. You note some very important points regarding some of our desires to meticulous save for retirement and how it could become counter-productive. However, I would like to offer a counter point to your statement that “Tax deferred accounts, does NOT mean tax avoidance.” Theoretically speaking, there is a small chance for an individual to legally avoid Federal Income tax on a portion of their contributions made to tax-deferred accounts in the year they take a distribution. Assuming an individual has no additional income streams besides SS and tax-deferred savings, the amount of funds received as a distribution would be tax-exempt up to the sum of their Standard Deduction and Personal Exemption – assuming our tax code still allows for these deductions in the future.

    • says

      Hi Ronald, that is a great point, and like you say assumes the tax code stays the same. :-) The other issue is I think long term we are in for a VAT, which even then things like a Roth accounts it means you still have to pay tax, just on consumption.

  3. says

    I think Roth would solve a lot of the problems you mention here. I always recommend about a 2:1 or 3:1 ratio of 401:roth contributions for the very reasons you mention above. I’d also like to bring up the point that should you ever have a period of reduced income(going back to school, laid off, etc) that is a great time to live off savings and rollover part of your 401k to a roth ira.

    • says

      Hi Harry that is if you qualify for a Roth IRA (meaning under income requirements), or can do the Roth IRA rollover option for high income earners. Otherwise yes without question on both statements you made.

  4. Josh says

    I guess I really never stopped to think if you could save too much for retirement, and have it hurt you. Just as you said though, I really don’t see myself being able to retire with the job I have right now. I can’t say that I completely trust retirement accounts either. This is a great article. Thank you for opening my eyes to something new.

  5. John says

    My personal opinion is that it depends on the financial situation of the individual. My wife and I reach the highest marginal tax bracket. We were putting some money into Roth 403b and backdoor Roth IRA accounts to diversify, but I recently changed our retirement allocation into tax deferred accounts. My rationale is that we are putting in “above the line” money that would be taxed at 45% plus between federal and state income taxes. When we withdraw the money, assuming it would be the sole source of retirement income, and starting out, every dollar up to the highest marginal rate would be taxed at a lower marginal rate than what we would have been taxed at now. This is of course assuming that tax rates don’t dramatically increase across the board.

    I have contemplated decreasing my yearly retirement contributions and putting more money into taxable accounts so it is liquid. I mean, how much money do you really need in retirement? They say 75% of your pre-retirement income, but I think that is not realistic or necessary when you reach a certain AGI.